A Look At Pure Cycle's Reimbursable Infrastructure Investments
Summary
- Pure Cycle makes major infrastructure investments at its Sky Ranch development for which it ultimately expects to be reimbursed, a portion of which it has already received payment for.
- Complex accounting rules limit the company's ability to book these expected reimbursements as receivables, or in some cases, even consider the cash already received when reporting revenue and income.
- It causes the profit on lot sales to be understated, or at least delayed. It also causes Pure Cycle's financial statements to be confusing, but creates hidden value.
- Understanding the accounting logic Pure Cycle uses for these reimbursables provides clarity in interpreting its financial statements.
- I also touch upon Pure Cycle's newly announced "Build-to-Rent" segment and the company's near-term prospects.
Source: Pure Cycle Earnings Presentation
Introduction
Pure Cycle Corporation (NASDAQ:PCYO) is a company with valuable assets that it is beginning to monetize in a significant way. These assets consist mainly of water rights, a scarce resource in the Denver metropolitan area (as well as many other portions of the west), along with a 931-acre property just east of the city of Aurora. This property, known as "Sky Ranch," has various approvals as a master planned community of about 3,400 residential units and over 2 million sf of commercial space, where development began in earnest in 2017.
Pure Cycle's assets were acquired at costs which were generally a fraction of their ultimate realizable value. As a result, the beginning of development of some of these assets was welcome news for many longtime Pure Cycle investors, not just because these assets are beginning to be monetized, but also because it is an affirmation of the unrealized value of the remaining assets.
Although the company's recent financial results are demonstrating that these assets are in fact being monetized quite profitably, the accounting rules Pure Cycle is required to follow results in a deferral of the reporting of some of the actual income being produced by lot sales in Phase 1 of Sky Ranch, which consists of 509 home sites. It also results in underestimates of gross margins as well.
I analyze the impact of these accounting rules (which I consider to be a bit unfair) on Pure Cycle's reported income. I also discuss the reimbursement process for the Sky Ranch infrastructure investments the company makes.
First, a Bit About the Legal Entity "Sky Ranch"
Sky Ranch is not located within the boundaries of any particular town or community but rather is simply a portion of unincorporated Arapahoe County. As a result, a legal entity known as a "Community Authority Board" was established, titled the Sky Ranch CAB. The various sections of Sky Ranch are further broken down into "Metropolitan Districts." Metropolitan District No. 1 consists of the residential property within Phase 1, for example. These entitles are described as "quasi-municipal corporations and political subdivisions of Colorado" in various Pure Cycle SEC filings.
Pure Cycle provides each purchaser at Sky Ranch a "Welcome Packet" which can be found here. It is an excellent document which explains in further detail various aspects of the governance of Sky Ranch.
One important paragraph at the beginning of the document contains the following:
The Sky Ranch Community does not have a Homeowner’s Association, instead the Authority performs such functions as covenant control, architectural review and grounds maintenance services, including but not limited to; open space areas and community parks, community fencing, monumentation, and snow removal along public parks and trails, as well as other management services for your community. These services are paid for through your yearly property tax assessment and Operations and Maintenance Fee, rather than through an assessment of dues such as an HOA would impose.
To sum things up, Sky Ranch has some elements of a homeowners' association and some elements of a municipality. The document goes on to describe the municipal entities providing various services and the taxes associated with those services. For example, it is within the Aurora school district (which is just to the west of Sky Ranch) and the Bennett fire district (which is a bit to the east).
Another key element of the CAB relates to who currently serve as members of its board of directors, as detailed on page 14 of the August 31, 2020 10-K:
The Sky Ranch Districts are governed by an elected board of directors. Eligible voters and persons eligible to serve as directors of the Sky Ranch Districts must own an interest in property within the boundaries of the district. We own certain rights and real property interests which encompass the current boundaries of the districts and certain of our employees serve on the boards of directors of the Sky Ranch Districts. The current directors of the districts are Mark W. Harding (our President, Chief Executive Officer and a director), Kevin B. McNeill (our Vice President and Chief Financial Officer), Scott E. Lehman (an employee of ours), Dirk Lashnits (an employee of ours), and one independent board member.
Because Pure Cycle owns the vast majority of the Sky Ranch property in these early stages of its development and because its officers and employees are most of the CAB's board of directors, Pure Cycle is considered a "related party". This situation is perfectly normal and akin to a sponsor controlling a condominium association prior to turning it over to the residents. However, it likely results in more restrictive accounting rules due to related party issues.
As a result, as I will discuss a bit later, it has caused in my view an unfair deferment of the reporting of some income, has resulted in an under reporting of the true gross margin on lot sales, and has created unnecessary "lumpiness" in quarterly reported net income.
Now the Numbers- Infrastructure Investments and Reimbursable Costs
Pure Cycle, as it develops Sky Ranch, makes improvements to the lots which are sold to builders for home construction and builds most of the necessary infrastructure. The infrastructure investments, at least in Pure Cycle's case, are almost entirely reimbursable. These reimbursable investments include roads, sidewalks, parks, and drainage systems.
Interestingly, it also includes "wet utilities" i.e., the water and sewer lines at Sky Ranch. Although Pure Cycle, as the water and sewer utility, will be responsible for ongoing maintenance of these lines, as a stockholder it's kind of nice that a certain portion of the initial capital investment is on someone else's "dime."
To project and report income on the lots, Pure Cycle needs to estimate the ultimate all-in development cost of each lot sold and then apply the appropriate accounting rules as lots are sold and revenue is booked. In its Q1 '21 conference call (QE Nov. 30, '20) on January 5, Pure Cycle provided an updated estimate of revenues and costs for the 506 lots in Phase 1 (filing 1) of Sky Ranch:
Pure Cycle divides Reimbursable Costs in the above table into two categories: "Current Reimbursables" and "Future Reimbursements." Current Reimbursables are amounts which Pure Cycle has spent for infrastructure at Sky Ranch AND for which it has already also been reimbursed.
"Future Reimbursements" in the table are additional amounts also spent by Pure Cycle for which it has a note with the CAB for repayment, and for which it ultimately expects to get reimbursed as well. This cost is verified by an independent engineer as being a reasonable cost for a "public improvement" which is ultimately paid for from property taxes from residents at Sky Ranch. The reimbursement is typically done though a bond issuance by the local municipal entity (the Sky Ranch CAB) which uses the bond proceeds to "purchase" the infrastructure from Pure Cycle at cost.
Total anticipated reimbursements, even before they are made, are an important component of the estimated total required investment and are critical in projecting overall project profitability.
Reimbursable vs. Non-Reimbursable Costs
I have used the above figures to create a few different tables. The first table separates reimbursable vs. non reimbursable costs. The $21.1 million of future reimbursements includes $1.5 million of anticipated but not-yet booked interest income on the future reimbursement amount. (I discuss details regarding this component a bit later.)
As a result, I have subtracted this interest from the future reimbursement amount to utilize a number representing true cost reimbursements separate from the potential interest earning component.
An interesting insight is that the vast majority of Pure Cycle's lot costs, including development expenses, are ultimately expected to be reimbursed. Although surprising at first, upon a bit of reflection, these figures do make sense. Most of the development cost is roads, sidewalks, drainage systems, parks etc., all of which are reimbursable. The lots themselves do not require much more than appropriate grading, and Pure Cycle's initial land investment costs were minimal.
Revenues and Gross Profits
In the next two tables, I present two different formats for the revenue and gross profit figures, one including the reimbursements as "revenue", the other one not:
Both tables report the same gross profit, $31 million, although vastly different revenues, costs, and gross margins. Depending upon the specific issue an investor may be focusing on, either approach is acceptable.
However, for most issues, I find the second table, with the 84.5% gross margin, a more enlightening one. Irrespective of specific costs of the infrastructure investments made by Pure Cycle, it can expect to be reimbursed 100% for those costs (within reason) and therefore they are not a relevant factor regarding Pure Cycle's actual and potential profitability.
Hidden Profits/Hidden Margins
The gross profits and gross margins Pure Cycle has reported so far are contained in the table below. In addition, I include the additional gross profit Pure Cycle expects to ultimately generate (mainly though a future bond issuance). These figures detail how Pure Cycle eventually expects to earn a total gross profit of $31 million, plus interest, from Sky Ranch's Phase 1. 
As is evident, Pure Cycle has been reporting much lower gross margins and gross profits than the figures I presented above for Sky Ranch's Phase 1, even though all of the infrastructure investments have been made and all of the finished lots have been sold. This is the result of what I view as an unduly conservative approach by Pure Cycle, presumably required by the company's accountants, and I suspect is at least partly due to the related party issue.
It is helpful to look at these numbers in a few different time frames. FY 2018 and FY 2019 were prior to the initial bond issuance in early FY 2020. Both years show minimal gross margins of less than 6% because none of the anticipated reimbursements could be considered in the estimated gross margins used by Pure Cycle.
If the reimbursables being created could have simply been booked as receivables to eventually be reimbursed at cost instead, Pure Cycle could have allocated 38% of the anticipated $32.5 million, or $12.5 million, as gross profit (based upon $14.1 million of an anticipated $36.8 million of revenue already booked) rather than the relatively miniscule $816,000 actually booked in those two years.
A similar situation will arise when Pure Cycle begins to report revenue and income for Phase 2/Filing 2. The company has estimated in its most recent earnings presentation that "Filing 2" will generate $72.6 million of lot sales revenue while incurring a total cost of $65.5 million, of which $48 million will be "Reimbursable."
This suggests to me that initial revenue and income reporting for Phase 2 will indicate a (greatly understated) gross margin of a bit less than 10% and considerably higher gross margins subsequent to any bond issuances. The ultimate result should be $55 million or so of gross profit (prior to interest earnings), almost double the anticipated $31 million for Phase 1, some of which will simply appear as "Other Income" rather than ever be part of the gross profit/gross margin calculation.
Punitive Accounting for a Bond Issuance
In the first fiscal quarter of FY 2020, Pure Cycle arranged for a $13.2 million municipal bond issuance by the Sky Ranch CAB, which is considered a related party, as discussed above. About $10.5 million of the proceeds were paid to Pure Cycle as reimbursement for infrastructure while about $2.7 million was placed into an interest reserve account as only a small portion of the planned homes in Phase 1 had been built and occupied at that time, meaning tax ratables were not enough at that time to service the debt.
Despite the fact that Pure Cycle had already spent considerably more than $10.5 million on infrastructure at that time, it could only take $6.3 million into income (60%) because that was the portion it had "earned" to date. At the end of that quarter, Pure Cycle had generated a total of $22.6 million of the projected lot sale revenue estimate of $37 million, roughly 60% of the expected total.
The remaining $4.2 million was used to reduce the carrying value of inventory rather than being reported immediately as income. The impact was that in subsequent quarters the reported gross margin improved significantly and now that all lot sales revenue from the builders has been recorded, the additional $4.2 million has been as well.
It should be noted that the $6.3 million of up-front income from the bond issuance was never reflected in the gross margin calculations but instead was simply recorded under "Other Income." The expected future bond issuance of $21.1 million will likely be recorded in the same fashion and therefore never be reflected in the lot sale gross margin calculation. Although ultimately the full profit is the same, the somewhat perverse result is that the lot sales look less profitable than the underlying economics suggest, while a simple reimbursement of actual costs appears as in the financial statements as the company's most profitable endeavor.
Some readers may note that there is a minor amount of less than $1.5 million of deferred lot sale revenue in the above table. This figure came from Pure Cycle's 10-Q, which listed the amount on the November 30, 2020 balance sheet. The deferred gross profit of $607,000 was "backed into" to reconcile the detailed numbers in my table to Pure Cycle's projected $32.5 million of projected gross profit.
As a minor side note, although the accounting for the lot sales and reimbursables is complex, this is an opportune time to be examining the figures. Because all of the lots in Phase 1 have now been transferred to the builders, the land development inventories on the balance sheet (which includes both reimbursable and non-reimbursable amounts) are in the unusual situation of being at zero as of November 30, which simplifies the analysis a bit. The figures are undoubtedly increasing again as Phase 2 land gets transferred into the inventory and as Pure Cycle makes investments on infrastructure improvements there.
Bond Issuance: Timing and Other Considerations
In addition to all of the accounting issues discussed above, there are restrictions on the amount of debt-service related property tax which can be imposed on owners at Sky Ranch. There are also various timing issues Pure Cycle management must consider. The combination of the accounting, timing and debt service issues presents some very interesting strategic considerations for the company. (Old Chinese Curse: "May you live in interesting times.")
The $13.2 million bond issuance highlights some of these issues. The credit quality of those bonds was determined both by actual and projected revenues available to service the debt. Based upon complex rules, an average home in Sky Ranch's phase 1 cannot be saddled with more than about $1400 per year of debt service as part of its tax bill. At the time the bonds were issued, there were not enough homes built to support the debt service for the bond issuance but there was an expectation that by FY 2021, there would be. This was the reason for the $2.7 million which needed to be placed in the interest reserve account.
Pure Cycle could have waited a bit longer to arrange for issuance of the bonds, which would have resulted in a lower interest reserve requirement, and therefore would have put more money in Pure Cycle's pocket. (Ultimately Pure Cycle expects to get 100% reimbursement, so it doesn't matter from that perspective.) It might have improved the credit rating of the bonds a bit as well, possibly reducing the interest rate. Issuing them much earlier would not have allowed the reporting of much income at the time and might have been problematic in any case.
However, Pure Cycle is permitted to earn 6% per year on unreimbursed infrastructure investments, another reason not to rush the bond issuance, particularly since the company is so highly liquid. Like the underlying remaining reimbursable, it cannot be booked as income until the cash is received, although the company does include $1.5 million of interest in its $21.1 million of off balance-sheet future reimbursements in the table at the beginning of this article. (Per page 13 of the November 30 10-Q: "As of November 30, 2020, the balance of the Company’s advances for improvements, including interest, net of costs reimbursed in November 2019, to the Sky Ranch CAB totaled $21.1 million, of which $0.3 million is included in Accrued liabilities, $19.3 million was expensed through Land development construction costs and $1.5 million of interest, which has not yet been recognized.")
This means that about $300,000 of interest is added to this not-yet booked receivable each quarter. Of course, Pure Cycle is beginning to make substantial reimbursable investments in phase 2, so the quarterly interest amount should actually increase until additional bond issuances are completed.... Every time I "peek under the hood" of this company, another future cash flow stream pops up...
How Municipal Bond Debt Can Phase 1 Support?
The short answer is possibly no more than the already outstanding debt, although this is an extremely complex issue about which I only have a partial understanding. It also appears that the commercial phase of Sky Ranch will be able to eventually make up for any shortfall in reimbursements in Phase 1 (or later residential phases) but first I attempt to analyze Phase 1 on a stand-alone basis.
The Sky Ranch "Welcome Packet" that I linked to earlier explains to new homeowners how property taxes are calculated and gives an example for a typical $350,000 home in Sky Ranch (which is now a typical $450,000 home). It was written prior to the debt issuance and indicates that the homeowner in the example could be subject to about $1393 in additional property tax to service the debt; the maximum debt is limited by the supplemental "mill rate" that can legally be charged.
Based upon $1393 per home, the 506 eventual homes in phase 1 would generate annual debt service capability of $700,000 or so per year at a minimum. The $13.5 million of bonds issued consisted of an $11.4 million senior tranche at a 5% coupon and a subordinate tranche of $1.76 million with more complex and variable terms. The total debt service requirements are generally in the $750,000 to $900,000 per year range over the next 10+ years and gradually increasing after that as increasing annual principal payments are due. I assume there is also an expectation that the revenue will be expected to increase gradually as well.
Based upon these figures, I am not anticipating any more reimbursements supported by Phase 1 tax revenue, but would not rule out an upside surprise. Once Phase 1 is built out, maybe some of the cash reserve can be released? Maybe the bonds with 5% and higher coupon rates can be refinanced??
The Benefit of Commercial Property at Sky Ranch
Commercial property is taxed at a much higher rate in Colorado; in fact, a commercial property can support roughly four times the debt service of a residential property, so a $350,000 commercial property could generate about $5500 of debt service revenue per year. This is due to the fact that although both residential and commercial property are taxed at the same rate based upon "assessed value," commercial properties' assessed values are 29% of estimated market values while residential properties are generally assessed at only 7-7.5% of estimated market values. (29% is four times 7.25%).
Unless you want to have a headache (I'm trying to exorcize mine), I would suggest just accepting the conclusions in the prior paragraph and moving on. However, for those who prefer to "trust but verify" there are many internet links which go into the topic of Colorado property tax in excruciating detail.
One issue is that although the 29% figure for commercial property appears to be "carved in stone," the rate for residential property can fluctuate a bit from year to year, (it apparently can go down more easily than up), which is why I gave a range in the prior paragraph. There have been various ballot measures to address this issue and there may be another one in 2022, but there also appear to be adjustments to ensure that debt service revenue will never decrease even though overall residential property taxes could decrease (part of a confusing discussion about "mill rates" in the Sky Ranch "Welcome Package" for those of us who do not live in Colorado).
The bottom line is that approximately 160 acres, 1/6 of Sky Ranch, is zoned for over two million square feet of commercial property. Of course, developed commercial property is generally worth much more than an equivalent amount of single-family residential property, so these 160 acres have an outsized impact, not just for the higher assessed value percentage, but for that reason as well.
As a result, Pure Cycle management is confident that all of its potentially reimbursable infrastructure investments at Sky Ranch will ultimately be reimbursed. The fact a that portion of Sky Ranch is zoned for commercial use, provides a significant benefit for the residential portion, a situation that may not be evident to most investors at first.
Pure Cycle's Entry into the "Build-to-Rent" Market
On March 11, Pure Cycle announced it was entering the rental housing market by building up to 100 homes at Sky Ranch and renting them out. Although the company only plans to build about 12 homes per year, it will do so with minimal cash outlay by borrowing most of the cash investment required. The company expects the homes to be immediately worth on average about $450,000, over $100,000 more than their investment cost and to generate about $33,000 per home in rental income while total annual outlays are projected to only be about half of that, including interest expense.
In addition to the press release, details are contained in a "featured presentation" on the company's website. It appears that the company is including in its cost the gross infrastructure investment per lot, most of which should ultimately be reimbursed in any case.
A Brief Look Ahead
Pure Cycle plans to announce its second fiscal quarter results, (ended February 28) on April 13. I estimate that the three builders at Phase 1 of Sky Ranch sold (signed contracts for) 60-70 homes in the quarter. This should generate a like number of tap fee sales to the home builders, worth about $2 million, who need to have "taps-in-hand" to obtain building permits. The lots in Phase 1 had previously been delivered to the builders, so there is unlikely to be any appreciable lot sale revenue from Phase 1 (other than some of the minor deferred revenue I mentioned earlier).
Presumably, the Phase 2 builders have made deposits, but, as happened in Phase 1, it is doubtful any of it can be recorded as revenue until certain milestones are reached, which may not happen until late this year. The "wild card" for the quarter just passed as well as the two upcoming quarters likely becomes whether water sales to energy companies for fracking purposes is becoming active again now that WTI is around $60/barrel.
in the absence of water sales, quarterly results may be unimpressive until we begin to see reported revenue for Phase 2. Of course, Pure Cycle has multiple revenue streams percolating under the service and becomes a bit more valuable every day.
I look forward to the upcoming earnings report.
This article was written by
Analyst’s Disclosure: I am/we are long PCYO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (55)
I appreciate your work over the past few years. Pure Cycle has moved way forward and has a very strong probability of meeting its goals over the next 8-10 years.
07/15/21 Bought 100 of PCYO @ $13.767 (Order #1771) Unassigned -1,376.70
07/15/21 Bought 70 of PCYO @ $13.77 (Order #1771) Unassigned -963.90
07/15/21 Bought 810 of PCYO @ $13.7699 (Order #1771) Unassigned -11,153.62Plus, water is a scarce resource. Lots of problems worldwide. Lots of solutions on the table. Will be interesting to see how it all evolves over the next few decades. Mining comets or the moon? I don't know. But it's not priced correctly, hence the huge world-wide waste. Which, again, is a good PCYO market force.
It makes Sky Ranch a slightly more attractive community to live in.
I'd like to see them purchase another water utility in the Denver area.
